A lot of people, especially younger people, like to think they can just kick the retirement can down the road until they are only a few years away from retirement and really need to get serious. There is one huge problem with this mentality though – we make important financial decisions much earlier than that!
There is not one, but a multitude of financial decisions that will have a material impact on a person’s financial future that they will face well before they have grey hair and are ready to retire. Some we make as early as when we earn our first paycheck. Unfortunately, many people avoid taking these financial decisions seriously, which even at a young age and modest starting salary, can have a material impact on your future financial health. Take, for example, a couple decisions many young people working their first job working their first job get to make: how much to save in their 401k, and which investment option to choose.
A common matching scheme with employers is matching 100% of the first 3% of the employee’s salary, and then maybe 50% of what they contribute past that, up to 6%. This is essentially free money from your employer, but you have to know to take advantage of it. Retirement plans often automatically enroll participants into something like a 3% savings rate, and it could be very easy to do nothing and default to this rate. Based on them matching scheme we mentioned earlier, this would result in a 3% employee contribution, plus 3% employer contribution, for a total contribution of 6% of the employee’s salary. A 6% savings rate is better than nothing but doesn’t take advantage of the full match. By electing to contribute an extra 3% of salary, for a total employee contribution of 6%, a person would receive a 4.5% match from their employer, for a total savings rate of 10.5%. Even on a low starting salary, a 10.5% savings rate can give a person serious traction when it comes to saving to achieve life goals.
Now there is another critical choice – what to invest in? This can have a material impact as well. Let’s use the last 35 years as an example – with a person who starts working in October 1980 making 40,000 a year, receiving inflation-like 3% raises each year, and saving 10.5% of their salary every year. How much could they have accumulated with each of the different basic investment options over the last 35 years at this rate?
As far as investment choices, savers have three options as far as broad asset classes.
1) Invest in Cash – Whether it’s in a savings account or under the mattress, it is pretty much all the same. For our example, we assumed cash provided a 0% return.
2) Invest in Bonds – To show the experienced investors would have had to save their money in bonds over the past 35 years, we used the returns of Barclays Aggregate Bond Index, a widely used index proxy for the total US Bond Market, with a .20% expense ratio.
3) Invest in Stock – To show the experience of stock investors over the same 35 year time period, we used the S&P 500 index because it is a widely available passive investment option in almost every 401k I’ve seen. We included a .20% expense ratio in the
How big of an impact can choose one asset class over the other really make?
The chart below sheds some light – and as always, we must mention past performance is no indicator of future results.
Because of the impact of compounding, the difference between making the “right” vs “wrong” choice originally is greatly magnified over the long term. Over the last 35 years, the stock investor ended up with just under $1.5 million, roughly twice the amount as the bond investor with roughly 760,000, and six times the cash investor with roughly 250,000! And the last 35 years were nothing exceptional as far as stock market returns either, with an annualized return 9.90%, this period actually fell .06% short of the annualized return on the S&P going back to 1926.
Consider the impact this has on a person’s lifestyle in retirement – using a 4% withdrawal rate, the stock investor can spend just under 60,000 per year in retirement, the bond investor can only spend around 30,000! I don’t even want to calculate the number for the cash investor because it would be too depressing.
The moral of the story is, basic financial decisions matter can have a huge impact on your life, especially the ones we make early on as the impact is magnified over a lifetime of compounding. Many people end up making bad decisions because they either don’t fully understand the impact of those decisions or they let emotions drive their decisions. Alternatively, many people end up not doing anything because they get paralyzed by information overload, lack of understanding, fear of regret, etc., which is probably the worst thing they could do.
I’ve brought up these decisions and possible mistakes not to scare people, but more to point out that with the right guidance, mistakes can be easily avoided. An advisor can help you make better decisions and avoid mistakes by ensuring you understand the implications of those decisions. Even if the only thing a financial advisor did was guide people into making basic financial decisions that are appropriate for your lifetime goals, he or she would add tremendous value their lives.